As outlined in our client publication of March 27, 2020 (Update for Borrowers and Lenders in Germany), by a new law effective since March 27, 2020 (the “German Covid-19 Insolvency Law Amendment”), the obligation of the management of a legal person pursuant to section 15a of the German Insolvency Act (“German InsO”) has been suspended until September 30, 2020 if certain conditions are met. The new rules shall provide the management with more time and flexibility to decide whether the company can be continued and shall help to avoid insolvencies caused by the circumstances triggered by the Covid-19 pandemic. The new rules do, however, not relieve the management from carefully and constantly observing the situation of the company and updating their assessment as the situation further develops. Making use of the additional rules may also impose personal liability risks on the managing directors. This memorandum shall outline a few aspects in relation thereto.
Applicability of the new rules: COMI in Germany
In accordance with Art. 3 of Regulation (EU) 2015, 848 of the European Parliament and the Council on insolvency proceedings (recast), the German InsO (and accordingly the new rules changing,, the filing obligations thereunder) only applies in respect of businesses that have their center of main interest (“COMI”) in Germany. The COMI is defined to be the place where the debtor (i.e. the insolvent entity) conducts the administration of its interests on a regular basis and which is ascertainable by third parties. In case of a company, the place of the registered office shall be presumed to be the COMI, but this presumption is rebuttable based on factual circumstances and it shall not apply if the registered office has been moved to another member state of the EU within a 3-months period prior to the request for opening of insolvency proceedings. The assessment of the COMI is more difficult when the registered seat deviates from the actual business address or the place where actual business decisions (e.g. for the (German) subsidiary of a foreign parent) are made. A move of the COMI to a jurisdiction with a different set of insolvency rules is in theory always possible, but its implementation, any risks of uncertainty arising and any pros and cons of such move need to be carefully considered on a case-by-case basis.
General Statutory Filing Obligations for Over Indebtedness
Pursuant to Section 19 German InsO a company is principally required to file for insolvency in case it is overindebtedness (Überschuldung). Overindebtedness shall exist if the company’s assets no longer cover its existing liabilities, unless it is more likely than not, considering the circumstances, that the company will continue to exist. In assessing such overindebtedness, the value of the assets is not to be determined on the basis of the statutory accounts (i.e. not on a going concern basis) but based on a liquidation balance sheet including the assets' liquidation value. This will often mean that the value of most assets is lower than stated in the statutory accounts and, in particular, the value of any subsidiaries must be scrutinized. However, it may also be possible that the company has hidden assets like intellectual property or real estate that are not (fully) accounted for at their actual market value in the statutory accounts.
Whether or not the company may continue to exist (notwithstanding the assets no longer covering the liabilities) depends on whether the business will be able to pay its debt as it falls due until the end of the following business year and there is no reason to believe that at the end of such period the liquidity will not be sufficient. Therefore, the management must prepare a thorough liquidity plan considering all expenses (including for any planned restructuring of the business).
General Statutory Filing Obligations for Illiquidity
In case a company cannot meet its payment obligations as they fall due, it must generally file for insolvency based on Section 17 German InsO. This does, however, not apply in case of a mere (temporary) payment stagnation. Thus, if the liquidity gap can be closed within a three weeks period or the liquidity gap does not exceed 10% of the liabilities due, no filing obligation exists. In case of disputed liabilities, management must prudently assess the likelihood of the payment having to be made.
Suspension under the German Covid 19 Insolvency Law Amendment
The filing obligations set out above, i.e. both in case of (i) over indebtedness (including the absence of a positive continuation prognosis) and (ii) illiquidity, have now been suspended until September 30, 2020 unless one the following two criteria is fulfilled:
If the business was not illiquid as of December 31, 2019, the law assumes that the insolvency is based on the consequences of the Covid-19 pandemic and that there are prospects that the illiquidity will be overcome.
At a first glance, the law seems to put little burden on management to make a thorough determination what the reasons for the insolvency are and whether the illiquidity will be overcome. Since, however, the above assumption is rebuttable, the managing directors of an insolvent business should ensure that (in hindsight) no creditor or insolvency administrator can reasonably rebut this assumption. In other words, the management - for its own protection – should carefully asses and document the situation, including by making and regularly updating a liquidity plan and documenting the underlying assumptions. This is in particular the case as the German Covid-19 Insolvency Law Amendment currently excludes the right of third party creditors to file for insolvency of a company only until June 28, 2020, i.e. after such date, third party creditors may file for insolvency even if the management of the relevant debtor would not be obliged to make such filing yet. In addition the third party rights to file for an insolvency are not limited if a debtor was insolvent on March 1, 2020.
It seems not fully clear at which time line the prognosis to overcome the illiquidity under the new law may look. This time line must certainly be longer than three weeks as otherwise only a stagnation of payment rather than an illiquidity would exist (see above). We tend to believe that the time at which the German Covid 19 Insolvency Law Amendment looks and during which the illiquidity must be overcome will be no later than September 30, 2020, i.e. the date until which the insolvency suspension lasts. This matches the reasoning of the new law which wants to provide the management with more time to make use of state aid and to make arrangements for their financing and restructuring with its creditors and financiers, However, this still requires a liquidity plan providing some prospects that the business can actually meet its obligations by such date, including a forecast that salaries can be (fully) paid (subject to relevant state aid available, like Kurzarbeitergeld in Germany), rent and taxes can be paid (unless a statutory deferment of payment can be claimed).
Risk of criminal liability
Notwithstanding the suspension of the obligation to file for insolvency, the continuation of an insolvent business generally bears the risk of criminal liability e.g. based on fraud (Betrug, section 263 German Criminal Code) or embezzlement (Untreue, section 266 German Criminal Code). Fraud may be considered if a business enters into contractual arrangements in a situation where it is likely that it will not be able to fulfill its obligations thereunder and such non-fulfilment causes financial damages of the contract partner (such as losing advance payments). In general fraud is committed if the assets of another party are damaged by causing or maintaining an error under false pretenses or distorting or suppressing true facts with the intention of obtaining an unlawful pecuniary benefit. Being silent on the financial situation of the company is therefore not necessarily sufficient to avoid criminal liability, as courts have confirmed a duty of the management to disclose the insolvency situation to contract partners if there is a particular relationship of trust. The existence of such a particular relationship of trust needs to be determined on a case by case basis. In addition, embezzlement, i.e. a breach of the duty to safeguard the pecuniary interests of another party which are incumbent upon them, may become relevant where a parent continues to receive cash loans under a cash pool arrangement notwithstanding the fact that the parent will no longer be able to repay such loans.
Whereas in normal times the period between the determination of the insolvency and the actual filing of insolvency should not exceed three weeks, such period may now last for up to six month under the German Covid 19 Insolvency Law Amendment. Obviously, the length of such period can increase the risk of management encountering situations that may lead to a criminal liability. Whether courts may in hindsight decide that everyone should have assumed the risk of insolvency of any business during and shortly after termination of the Covid-19 pandemic and would accordingly be less inclined to conclude fraudulous behavior cannot be currently predicted.
Pursuant to the German limited liability company act (GmbHG) and the German stock corporation act, the management of a German GmbH or Aktiengesellschaft becomes personal liable for the repayment of amounts paid after a limited liability company or stock corporation has become illiquid or is deemed to be over-indebted, unless such payment is compatible with the due care of a prudent businessman (a “Prohibited Payments”). Managing directors should assume that the concept of Prohibited Payments also applies to businesses organized in a different form but having their COMI in Germany. Prohibited Payments means that the insolvent company after that point in time is only permitted to make payments that are either required to continue the business (provided there is a real chance for a restructuring) or which can be expected to directly or indirectly increase the future insolvency estate. As the limitations set by these provisions are rather narrow, in practice management should take professional advice before making any payments.
Under the German Covid-19 Insolvency Law Amendment, if and when the filing obligations of a GmbH or Aktiengesellschaft are suspended as set out above, all payments “in the ordinary course of business” shall (during the time of such suspension) be considered to be in line with the above provisions. This shall, in particular, apply to payments that serve the continuation or resumption of the business or the implementation of a restructuring (including by an adjustment of the business focus). However, in order to rely on this relief, the managing directors still need to ensure (and document) that the requirements of the insolvency filing suspension are indeed fulfilled and that the payments are in the ordinary course of business (as it stands at that time).
Alternative: Protective Shield Procedure
In this present difficult situation, it may, however, not always be the best solution to avoid an insolvency filing even if this was permitted under the German Covid 19 Insolvency Law Amendment. Rather, in order to bring the company “back on track” in the medium term, it may be an option to enter into protective shield proceedings pursuant to Section 270b of the German InsO.
Such protective shield proceedings are only available if the company is not yet illiquid (pursuant to section 17 of the German Ins), but imminently illiquid (section 18 German InsO) or overindebted (section 19 German InsO). The initiation requires a filing accompanied by a certification (with grounds) provided by a tax advisor, accountant, lawyer with experience in insolvency matters or another person with comparable qualifications, evidencing , inter alia, that the intended restructuring does not manifestly lack the prospect of success.
The implications of the protective shield proceedings, many of which can be beneficial compared to regular insolvency scenarios, are:
At the end of the fixed period, the insolvency court decides on the application to open insolvency proceedings. In case the creditors and the court approve the presented insolvency plan and no reason to open insolvency proceedings exists based on such plan, the court may suspend the protective shield proceedings and the company can implement the actions set out in the insolvency plan in an out-of-court scenario.
The protective shield proceedings are not addressed in the German Covid 19 Insolvency Law Amendment and whilst the obligation to file for insolvency is suspended under the German Covid 19 Insolvency Law Amendment, filing for and entering into protective shield proceedings remains open for companies that satisfy the above-described prerequisites.
While the German Covid-19 Insolvency Law Amendment can be very helpful to prevent insolvencies on a short-term basis, it is unclear to what extent it can reach such target on a long-term perspective for businesses that are severely hit by the current shut down if this situation does not end sooner rather than later. In particular, in many businesses where a catch-up of lost revenues is not possible, the incurrence of additional debt to overcome Covid-19 related liquidity constraints will leave companies with an unsustainable amount of debt. In any event, the management of an insolvent entity with its COMI in Germany needs to constantly review and document the commercial and financial situation of the company in order to ensure that the company and its management can effectively benefit from the reliefs provided by the German Covid-19 Insolvency Law Amendment. Any director violating the statutory rules in their transitional form continue to incur civil and criminal liability.